When Should a Child's UTMA or UGMA Account be Moved into a 529 College Savings Plan Account?

I have an old UTMA account for my daughter with Janus, with approximately
$5,000 in gains. I opened this before they even had 529 college
savings plans. I was thinking of transferring this to a 529 account
with NYSaves.com. My daughter is 13. Is it worth transferring this
UTMA account to a 529 and paying capital gains now, or is it best to leave
it with Janus (and pay when I take it out for my daughter’s college
costs), and open a new 529 where I can make separate contributions?
— S.J.G.

An UGMA or UTMA bank or brokerage account is considered to be a child
asset on the Free Application for Federal Student Aid (FAFSA). A child
asset will reduce eligibility for need-based aid by 20% of the value
of the asset. This is in contrast with parent assets, which reduce aid
eligibility by at most 5.64% of the asset value. If a family expects
to qualify for need-based financial aid, they should consider the
difference in treatment of child and parent assets when making
investment decisions.

The FAFSA bases the expected family contribution (EFC) on student and
parent income during the tax year prior to the award year. For
example, the EFC during the freshman year in college will usually be
based on income during the spring of the junior year and fall of the
senior year. Families who expect to qualify for need-based financial
aid should try to minimize capital gains during the prior tax year,
since this will artificially inflate income. Eligibility for
need-based financial aid is reduced by 50% of the student’s income
after subtracting a small income protection allowance. It is better to
realize capital gains in the second prior tax year or
earlier.

Thus waiting until the year before the child enrolls in college to
take the capital gains will hurt the child’s eligibility for
need-based aid twice, once as income and once as an asset.

The treatment of the earnings as income can be addressed by realizing
the capital gains sooner. (Contributions to a 529 college savings plan
must be made in cash, so there’s no way to move the money into the 529
plan without realizing capital gains.)

The treatment of the investment as a child asset can be addressed by
investing the money in a custodial 529 college savings plan. This 529
plan will be titled the same as the UGMA or UTMA account, with the
child as both the beneficiary and the account owner. The College Cost
Reduction and Access Act of 2007 changed the treatment of
custodial 529 plan accounts from a child asset to a parent asset,
effective starting with the 2009-10 award year.

Families should also consider the tax impact of liquidating the UGMA
or UTMA account. Short-term capital gains are taxed as ordinary
income, while long-term capital gains are usually taxed at a lower
rate.

It is possible to have multiple 529 college savings plans for the same
student. For example, one 529 plan could be a custodial 529 plan owned
by the student while the other could be owned by the parent.

Incidentally, New York opened its 529 college savings plan in
September 1998. Other states had 529 plans available as early as
1996.